The decline in liquidity in over-the-counter variance swaps on Sept. 1 when the U.S. Commodity Futures Trading Commission’s uncleared swap margin rules came in to force are another indication that investors should look to variance futures to build a position in realised volatility, according to market participants. On Sept. 2, the CFTC issued a no-action letter to swap dealers to extend the collateral rule deadline due to limitations with custodial accounts. Lawyers note, however, the CFTC relief to swap dealers only applies to custodial accounts, and further work needs to be done by some dealers surrounding margin calculations, systems and documentation.


Equity derivatives salesmen at European and Asian firms noted that liquidity particularly in the variance swap market on Sept. 1 took a hit as many U.S. counterparties had not finalised with international counterparties margining documentation and calculations. “Basically, banks hadn’t signed each other up quick enough and that meant you just couldn’t face the U.S. banks. For variance swaps where you margin each other, going forward it will be more expensive but in the meantime if those entities aren’t papered you can’t trade facing bank counterparties so this effects liquidity, novation, the lot,” noted one equity derivatives salesman.

As liquidity in OTC variance swaps has struggled in recent days, a spike in interest has been seen in variance futures in Europe from sellside traders and portfolio managers. The key questions from participants have surrounded variance futures margin methodology. Eurex, which has been fielding increased calls from investors on variance futures as the margin rules deadline for U.S. banks approached, is responding on margining calculations. In November, the exchange will include volatility derivatives into its PRISMA- Risk Management offering cross-margining with Euro STOXX 50 options. This means banks that trade variance futures from November can receive capital efficiencies via cross-margining with Euro STOXX 50 options.

“Most variance swap counterparties have very large portfolios of Euro STOXX 50 options with Eurex and need to post across the margins so this introduction in November can provide sizeable margin relief for participants,” said Sascha Semroch, product manager in equity and volatility derivatives at Eurex in Frankfurt. “The benefit of the variance futures is that you can trade in and out with different counterparties and you only have one net position per expiry instead of a dozen line items, which also offers benefits in risk management as you don’t have to revalue each variance swap individually. With the variance futures you have real time risk, real time PnL and you have one net position.”

The consensus from equity derivatives salesmen and portfolio managers is that in the next month U.S. dealers will have in place the necessary systems, calculations, documentation and agreements surrounding margining to trade variance swaps and other OTC products that are subject to the margin rules. However, there is confusion among participants, since the no-action relief from the CFTC only applies to custodial accounts, meaning that U.S. firms still have to have the necessary systems and documentation in place to trade uncleared swaps subject to the margin rules.

The institutions and banks that are subject to U.S. prudential regulation do not have the benefit of the CFTC relief. The CFTC relief is also rather limited, it’s rather technical and it does not give general relief from the requirements to post and collect initial and variation margin. Instead, the no-action relief gives temporary relief from the requirement to have a custodial agreement in place with an unaffiliated custodian,” said James Schwartz, of counsel at Morrison & Foerster in New York. “So in terms of the substance, you still need to post and collect margin if you are a CFTC or prudentially regulated swap dealer. However, if you’re not a registered swap dealer or a major swap participant then, unless you contract with someone who is subject to the margin rules, then you are not subject to those rules.”

Julian Hammar, of counsel at Morrison & Foerster in New York, added that the inability of some U.S. dealers to trade uncleared swaps subject to the margin rules could come down to a number of reasons, such as a technical factor, their systems are not correctly set up or that they don’t have the custodial agreement in place and so they can’t post variation or initial margin.

“Also, are we even sure that all the initial margin models have been approved, because if the margin models are not approved then you need to go to a much more expensive method of calculating margin. And the further point even beyond that is whether all the banks have had an opportunity to fully implement those models in to their front of office system. So there is a whole bunch of reasons why they may not be able to participate in a certain trade,” noted Hammar.

The CFTC has given swap dealers until Oct. 3 to comply with the custodial arrangement requirements of CFTC regulation 23.157. Last week, Timothy Massad, chairman at CFTC, released a statement last week noting that CFTC understands the situation has improved. “The largest dealers may no longer face significant issues, staff has heard that smaller firms or foreign firms may not have been able to complete all arrangements or test these new facilities,” he noted.

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